3 trades to make if Italy quits the euro

Commentary: How to make money on the ‘Quitaly’ play

By

MatthewLynn

LONDON (MarketWatch) — The Greek debt has been fudged. The Spanish banks have been salvaged for now. But the one thing we have learned for certain about the euro crisis over the last three years is that as soon as one monster is slayed another one very quickly takes its place.

Right now it is Italy. Plenty of people — including this columnist as it happens — have predicted that Italy would be the stage for the next chapter of this saga, and quite possibly its final denouement. Now it is coming to pass.

Give (investing in) Greece a chance

The technocratic Prime Minister Mario Monti, parachuted into office by Brussels and Berlin to reform the Italian economy and rescue it from a bailout, has been deposed. The stage is now set for a bitterly contested election in which the country’s continuing membership of the euro will be the main issue.

An Italian exit from the euro is now a realistic option. So how should investors play the ”Quitaly” (for Italy quitting) trade? By shorting Italian bonds, getting out of the banks — but also getting ready to buy Italian equities.

Elections were always due to be held in Italy by April next year. Now they look set to be held in February. Silvio Berlusconi has pulled the plug on the man who conspired to remove him from office. Not surprisingly, the markets took fright. Italian equities were hammered on Monday and bond yields spiked dangerously upwards.

Reuters

Silvio Berlusconi may not return to power, but his opposition to the euro could be credible enough to influence markets.

Just as in the Greek elections, it looks as if there will be a huge vote against the euro and against austerity. Berlusconi has adopted an increasingly anti-euro stance.

He has openly questioned Italy’s continued membership in the euro, and this week again was attacking German economic control of Europe. “The Monti government has followed the Germano-centric policies which Europe has tried to impose on other states and it has created a crisis situation which is much worse than where we were when we were in government,” he said in a television interview this week.

Berlusconi is not the force he once was, and is unlikely to win the election on his own. But he has allies in the anti-euro camp. The protest Five Star party, currently running second in the polls, is calling for a referendum on membership in the single currency. So too is the separatist Northern League. While the center-left may well win — it is ahead in the polls — at least 40% of the electorate will vote for anti-euro parties.

Remember, it doesn’t take the anti-euro forces to win, or to be ahead in the polls, for the markets to panic. With 1.9 trillion euros of debts outstanding, Italy is the third-largest sovereign borrower in the world after the U.S. and Japan. Would you want to be holding Italian bonds while an election campaign was being fought in which one plausible outcome was the re-introduction of the lire? Of course not.

Nor should a victory for the center-left be taken for granted whatever the polls say now. Italy is a country in a deep recession. The economy will contract by 2.4% this year, according to the latest government forecasts. Unemployment is up past 11%, its highest level in 13 years and up from 8.8% a year ago. It is rash to assume Italians will vote to continue with policies that have created that mess. In a deep recession, voters are angry, and they lash out in unexpected ways.

In truth, whoever wins the election, there is going to be a showdown. If it is a center-right leader — either Berlusconi or one of his allies — it will be because they have serious doubts about the currency. If it is the center-left leader Pier Bersani it will be because he needs a better deal to stay in power — no leader of a democracy has much of a future with an economy shrinking at 2.5% a year.

The best card for any Italian PM to play is to threaten to quit the euro. Why? Because that will force Germany to relax austerity. As the Greeks have shown, when it comes to the crunch, the Germans will compromise rather than let a country leave. If they have to, they will dig into their pockets to find some more bailout money.

So how can investors play that? Three ways.

First, short Italian bonds. In the new year, it will be in everyone’s interests to see Italian bonds yields shoot up. Both Germany and European Central Bank will want yields to rise to force Italy back into line on austerity — it was by triggering a crisis in the bond market that they managed to get rid of Berlusconi in the first place. But Italy’s leaders — whoever they are — will want to see them up to strengthen their hand in negotiating with Frankfurt, Paris and Berlin. If everybody wants something to happen, it usually does.

Next, short banks, not just in Italy but around the world. Italy has borrowed 1.9 trillion euros. True, much of that is held domestically, but a lot of those bonds are sitting on the books of banks everywhere. As the Italian bond market wobbles, there will be some very nasty losses to be endured on those assets. And if the prospect of Italy leaving becomes realistic, the banks will have to write those off. The results won’t be pretty.

Lastly, get ready to buy Italian assets. Italian stocks
FTSEMIB, +0.61%
will get hammered as the crisis gets played out. It is already among the cheapest major markets in the world, but it will get cheaper still. And yet there are lots of good quality global companies in Italy. Unlike Greece, this is a serious, productive nation. And whichever way it works out, Italy will reflate, either because Italy leaves the euro, or, more plausibly, because the austerity program will be relaxed. Stocks will do well from that.

Don’t expect to buy at the absolute bottom. Prices will get very cheap in the next two months as the election looms and the anti-euro rhetoric gathers strength. There will be plenty of opportunities to trade the crisis.

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